EU deal is game-changer but many issues remain

OPINION:Germany’s acceptance of greater burden is a major stride and should benefit Ireland’s debt situation. But deeper integration is needed, writes
DONAL DONOVAN

THE DEAL reached by EU leaders in the early hours of Friday has been hailed by many, including Taoiseach Enda Kenny, as a “game changer”. But only time (and the markets) will tell whether it can halt the flood of negative prognostications about the euro.

In the end, the leaders did not discuss far-reaching recommendations on the future architecture of the euro area contained in a report by the heads of the European Council, the European Commission, the European Central Bank and the euro zone ministers. Consideration of their call for a deepening of fiscal, banking and economic integration in Europe has been put back until the next summit in October.

However, Friday’s agreement marks a significant shift in the heated debate on a more pressing immediate issue: who is going to pay what part of the debt that has resulted from the excesses of the last 10 years and from the banking debacle? The northern countries (essentially Germany) will foot a greater share of the bill, while the burden to the citizens of the affected debtor countries will be correspondingly less.

The Spanish government (and hence Spanish taxpayers) is thus the big winner. By agreeing to the principle that the new permanent rescue fund, the European Stability Mechanism will finance the recapitalisation of distressed Spanish banks directly, without a Spanish government guarantee, the ESM takes all the risk that this entails upon itself. The Spanish taxpayer is off the hook.

Ireland is also a potential major winner. The key sentence of the communique following the reference to bank recapitalisation states that: “The euro group will examine the situation of the Irish financial sector with a view to further improving the sustainability of the well-performing adjustment programme”.

It had always been thought quite likely that the approach eventually followed for Spain would be applied retroactively to Ireland. Nevertheless, it was very important for the Irish side to insist that the communique say this explicitly.

What this means in practice for Ireland is very difficult to tell at this stage. Ireland’s banking debt has been under discussion with the European Union-EU-International Monetary Fund troika for well over six months without, it seems, any significant progress. However, the high-level political commitment contained in the communique should be a major impetus to achieving an acceptable outcome for Ireland.

An eventual deal might involve retroactive ESM funding of part of the recapitalisation of banks other than Anglo and a restructuring of the promissory note/emergency liquidity assistance arrangement vis a vis the ECB (perhaps also involving the ESM). The likelihood of some or all of this happening has improved significantly. But a persistent and skilful negotiation will be required for the Government to make this happen.

Another winner is Italy as the deal appears to commit the ESM to intervene in the markets to counter excessive upward movements in Italian bond spreads. While allowed for under ESM rules, to date Germany opposed implementing this approach. Now, although intervention will be subject to significant conditionality (including agreement by all ESM contributors), there is a much greater chance that spreads can be kept within tolerable limits.

The ECB should feel pleased that it is the ESM, rather than the bank, which has been entrusted with intervention to support governments facing market stress. This represents a victory for German thinking which has long being concerned that involving the ECB in such operations represents a serious threat to the bank’s financial and political independence.

The long-term future of the euro has also been strengthened in a very major way by the decision to expedite creation of a pan-European banking regulatory system. Germany insisted on this as a precondition for the ESM undertaking bank recapitalisation. In any event, a centralised approach to financial regulation, together with stricter adherence to fiscal rules, are the key ingredients in a fundamental reform of euro area architecture. Their absence contributed greatly to Ireland’s banking and fiscal disaster.

It is important Ireland supports the plan for pan-European financial regulation and does not try to opt out by seeking special treatment, for example, for the IFSC. A “cherry-picking” approach could undermine seriously Ireland’s chances of maximising the benefits of last Friday’s overall deal.

Who are the main losers, at least from a short-term financial perspective? As the major contributors to the ESM, Germany (and some other northern countries) are assuming the risk associated with lending to distressed banks without a back-up guarantee from the Spanish (or potentially Irish) governments. Extensive ESM purchases of Italian bonds also entail financial risk if market sentiment does not rebound sufficiently. The ESM’s exposure is compounded by the decision to strip its lending to the banks of “senior creditor” status. This means that if its investments in the banks turn sour (as is quite possible), the ESM – and hence Germany – will end up carrying a heavy can.

Angela Merkel, all too aware of the implied shift in the financial burden for Germany, resisted these proposals to the bitter end. However, the German government could not escape the reality that if a Spanish or Italian financial crisis is to be staved off, it has to commit itself to paying a larger share of the bill. Whether at some point the cost for Germany becomes unacceptably high will be determined by two factors. First, the market’s willingness to absorb German debt without threatening its triple-A credit rating; and second, Merkel’s fate at the hands of the German electorate.

Donal Donovan was a staff member of the International Monetary Fund from 1977-2005 before retiring as a deputy director. He is adjunct professor at the University of Limerick and a visiting lecturer at Trinity College Dublin. He is co-author with Antoin Murphy of a book, The Fall of the Celtic Tiger, to be published by Oxford University Press

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